Earnest Money –Is it necessary?

When you are writing a contract offer on a house one of the decision you and your Realtor will need to make is what amount of earnest money you should offer to be held in escrow. What this means is you make a deposit with a third party (typically the title company) showing the seller that you are willing to put some skin in the game to show you are serious about the deal. This amount is typically $500 or $1,000 in the KC area. However, it can be of any amount. And doesn’t have to be money. It can be anything you and the seller agree on. It can be a necklace, a boat, a cow, you name it.

For simplicity purposes, from here on out I will speak of thing in terms of this deposit being money.

There are a few things you need to know about the earnest money deposit. The first is, the check will be deposited into an escrow account. Therefore you must have the money in your account. Secondly, if you follow through with the contract and purchase the house, that money is credited back to you at the closing table. Third, if you walk away from the deal for a reason not covered in the contract, you will forfeit the money to the seller.

Now the tricky part. There is another level to this most people do not know about. If the contract gets cancelled for any reason and never makes it to the closing table, both parties have to sign the release form to allow the money to be given to the other party. You read that right. Both parties. So what happens if one side chooses to not sign it? The answer is it sits in limbo in that escrow account until one of three things happens. One is that both parties come to an agreement and sign the form. Two is that one party takes the other to court and gets a ruling from the court to have the money released to them. And three, the money is not released and after a couple of years becomes possession of the state.

Now that we know what earnest money is, and how it works, let’s look at the reasons for it, and against it.

First, why you need to do it.

As I mentioned before, this is showing the seller you are serious about your offer and you are willing to put up some money to prove it. This says to the seller you are willing to give them that money if you do not go through with the contract. In a hot market, this could be the difference in getting your offer accepted, and getting put in the trash can. In some instances, it might be more important to the seller than the actual offer. I say that because what good is a higher price offer, if it isn’t serious?

Additionally, by accepting a contract, the seller essentially has to take the house off the market while you go through the contract timeline. Technically, it is still for sale and can allow backup offers. But houses in backup status are far less viewed than those that are active. So the earnest money gives them peace of mind that if the buyer walks away, they can be compensated for the time their house was not actively for sale.

So there are the reasons you need to offer an earnest money deposit. Now for why you maybe shouldn’t.

As a buyer, you are the only party that is taking any kind of financial risk with offering a contract on a house. Two of things you will be paying for are the home inspection and appraisal. Both of which are typically paid outside of closing by you out of pocket. Whether the deal consummates or not. Add on the earnest money, and you could be looking at a few thousand dollars you are paying out that can all be lost if the deal falls apart. And it doesn’t even have to be the buyers fault!

The question then becomes, should the buyers being putting themselves at more risk than absolutely necessary? Does the earnest money deposit matter that much? For years the real estate community has shown that it does feel that it is a necessary part of the deal. But it seems like this is one of those, “the way it has always been done” type of things. And nobody wants to be the first one to stray from the herd.

As I encounter the use of earnest money, from both the buyer and seller side, I can’t help but to feel like the earnest money deposit is an overrated component to the deal. That the risk/reward on the buyer’s side isn’t very good. When you get right down to it, you might as well be gambling with that money. Because you are gambling that if something happens, that the seller will be understanding and not hold the money hostage by refusing to sign the release. Which does happen.

So what is the remedy? I wish I knew. Because I do think there needs to be some reform in this area. Perhaps contracts need to be written in a more specific way that allows the money to be released without signatures for specific situations. Or maybe use a third party moderator to determine the release or non-release of the money. Just so that the decision making is done on facts, not emotions.

Maybe there will come a day when there is some change, maybe not. But hopefully this will give you something to think about the next time you are buying or selling a home.